Budget cuts in prisons in England and Wales are reducing regimes to the minimum, risking stability and jeopardising rehabilitation, the chief inspector of prisons warns today.

Dame Anne Owers, in her final annual report before she steps down this summer, says that the expanding prison population, combined with more cuts to come, is producing hidden pressure within the penal system.

"The new benchmarking process for key regime activities is at least honest – clarifying what can actually be delivered within limited resources," she writes. "But it is also an exercise in regression to the mean. Prisons doing excellent work are being told to aim for the bronze standard [rather than gold], prisons with full employment are told this will not be affordable; innovative work, outside formal and mandated interventions, is under threat."

The chief inspector said progress has been made since she took on the job eight years ago, with a focus on decency changing the culture in prisons in England and Wales and the expectations of staff.

"But in spite of the progress made, prisons remain caught between the irresistible force of an increasing population and the immovable object of budget cuts," she said. "Population pressure affects the whole system – stretching resources, keeping in use buildings that ought to be condemned, doubling up prisoners in cramped cells.

"Prisons are larger and more complex. Resource pressures are at present being contained, but should not be underestimated. There are two risks: of increased instability in inherently fragile environments and of reducing prisons' capacity to rehabilitate those they hold."

Owers illustrates her annual report with prisoners' paintings showcased in the 2009 Koestler awards exhibition to highlight the importance of preserving art and drama to aid rehabilitation.

The chief inspector discloses that she has £150,000 extra funding to mount more unannounced inspections following the "prisoner swap" scandals at Wandsworth and Pentonville, when managers tried to undermine inspections.

The report also highlights:

• The success in reducing suicides in prisons from 95 in 2002 to 60 in each of the last two years although self-harm remains prevalent and shocking, particularly in women's prisons.

• That resettlement is now regarded as a core part of a prison's function but sentence planning for the majority has declined as "offender management" of a minority has been introduced.

• The male prison population is now 28% higher than in 2002, following the introduction of indeterminate sentences for public protection without the resources to provide the interventions they need.

• Worrying signs that progress has halted in immigration removal centres, with all new centres being built to prison-like specifications.

The prison inspectorate has published 103 reports into conditions in custody in prisons, immigration removal centres and police cells. Although currently subject to two reviews by the Treasury and Cabinet Office over its future independent role, the inspectorate is now the official UN guarantor against the use of torture and inhumane and degrading treatment in custody in Britain.